Chapter 7: Bonds and Bond Valuation A bond is an IOU issued by either the government (federal, state, or municipality), corporations, or households. The debt obligations are large and growing at rapid rates such that events in debt markets have wide-ranging impacts on the economy. The categories of debt are federal government debt, tax-exempt debt issued by state and local governments, corporate bonds, mortgage debt, and consumer credit. The considerable variability of interest rates significantly increases the importance of debt financing decisions both for borrowers and lenders. For participants in the financial market (households, businesses, government, and financial institutions), the stakes in the interest rate game are large. In environments of variable rates, there are two important interrelated decisions to both borrowers and lenders: 1). When is the best time to issue debt? 2). Should short-term or long-term debt be used? The timing of when to issue debt or when to borrow depends upon the expectation one has of the direction that interest rates will take. The yield curve is a graph that shows the relationship between the yield and maturity (time). Bond prices are inversely related to the market interest rates or yield to maturity. That is, when market rates go up, bond prices go down and vice versa. This implies that since current yield = coupon payment/bond market price, the current yield is directly related to market interest rates or yield to maturity. That is, when market interest rates go up, yields also go up and vice versa. An upward sloping or normal yield curve shows that long-term interest rates are expected to be higher than short-term interest rates. In this environment, lenders should lend short so that they can get their money back quickly and be able to lend out at higher interest rates. On the other hand, borrowers should borrow on long-term basis so that they can lock in lower rates. A flat yield curve shows that long term and short term interest rates are expected to be the same. In this environment, you can lend or borrow short or long. A downward sloping yield curve shows that long-term interest rates are expected to be lower than short-term rates. In this environment, lenders prefer to lend long so that they can lock in loans at higher rates while borrowers prefer to borrow short so that they can get more debt later at lower rates. There are

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